Analysis: Yen could drop further as carry trade picks up steam

TOKYO (Reuters) - Spiking U.S. bond yields and super-loose Japanese monetary policy are reviving the yen carry trade, which could spell more weakness in the currency after its biggest two-month drop in three years.

The yen was last in vogue as a cheap global funding vehicle for buying higher-yielding assets in 2005-2008, before the global financial crisis sent investors fleeing to the exits.

Now with a global economic recovery slowly picking up steam and Europe's debt crisis seemingly off the boil, traders are again looking to sell the low-interest rate yen to raise cash for forays into riskier and more rewarding assets.

With U.S.-Japan interest rate differentials narrow until mid-March and geopolitical risks troubling investors, many investors were skeptical the yen carry trade would make a comeback for the first time since the Lehman Brothers collapse.

But after a steady stream of encouraging news in recent months about the U.S. economy, traders expect the carry trend to make a comeback - and this time for good.

"We are coming out of a very long period of severe risk aversion and the liquidity pumped in by the central banks is eventually being put to work. That's why the yen carry trade is not a bad place to be," Pierre Lequeux, head of currency management in London at Aviva Investors, which manages about $424 billion.

"Look at what happened to all yen crosses from the beginning of the year. We have seen big gains because long-term investors have to move away from bonds and go for higher risk premia."

Rising U.S. short-term bond yields are making the dollar less attractive as a funding currency, leaving the yen as the main alternative. A surprise decision by the Bank of Japan in February which signaled a more aggressive policy easing stance has cemented those expectations.